The third quarter began with global financial markets coming to grips with the Brexit vote on June 23rd 2016. Central banks across the globe were quick to respond to the event, renewing their commitment to do what was required to backstop the global economy and financial markets. With the potential impact of Brexit lying further out into the future, perhaps years, equity markets rallied swiftly in July. The S&P 500 gained 3.7% in July while the MSCI EAFE Index and the MSCI Emerging Markets Index (both in USD terms) rose 5.1% and 5.0%, respectively.
Between the middle of July and the beginning of August, we saw a significant drop in volatility. The VIX index, which measures implied volatility of S&P 500 Index options fell to 11.34 on August 19th, the lowest level in more than two years. The S&P 500 went forty-three days without a 1% move (up or down), marking the tightest 40-day range in its history (based on closing prices). Our own proprietary volatility forecast for the entire U.S. equity market, measured on a daily basis, showed volatility dropping to levels not seen since February 2007.
Equity markets fell after the first week of September, and market volatility picked up, amid uncertainty leading into the Federal Reserve’s September 20th-21st meeting. The Federal Reserve opted to keep rates unchanged at the meeting, giving equities a boost as the quarter ended. The S&P 500 index gained 3.9% for the quarter while the MSCI EAFE Index and MSCI Emerging (both in USD terms) posted gains of 6.46% and 9.19%, respectively.
The general risk-on environment of the third quarter was also reflected in falling high yield spreads. The Bank of America-Merrill Lynch US High Yield Option Adjusted Spread fell 124 basis points to 4.97 by the end of the quarter, its lowest level since July 2015. At the same time, US ten-year treasury yields finished the third quarter at 1.60, close to its lowest level of the cycle and just 11 basis points higher than where it finished the prior quarter. The yield curve also flattened slightly amidst continuing concerns that the Federal Reserve is more than likely to tighten amidst low inflation. The difference between the ten-year and two-year yield fell 8 basis points over the quarter to 0.83.
The Spouting Rock/Convex Global Macro Fund (Institutional and Advisor Classes) (CVXIX and CVXAX) gained 1.72% in the third quarter of 2016, compared to a return of 0.10% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index. As of 9/30/16, the Spouting Rock/Convex Dynamic Global Macro Fund average annual returns since the fund’s inception on 11/24/14 are 0.75% for CVXIX and 0.46% for CVXAX, compared to 0.16% for its benchmark. The returns for the one-year period ending 9/30/16 are 7.01% for CVXIX and 6.68% for CVXAX, compared to 0.27% for its benchmark.
US economic growth in the third quarter is expected to rebound to about 2.0-2.5% real GDP growth (Atlanta Fed GDPNow forecast) after a lackluster second quarter, when real GDP grew only 1.4%. We do note that inventory drawdown was mostly responsible for a disappointing second quarter, where as consumer spending grew 4.3%. The headwind from inventories should ease in the second half of the year even as personal consumption remains strong. Auto sales appear to have peaked but were still close to record levels in the third quarter. New home sales, whose economic impact is larger than existing home sales, surged to a 659,000 seasonally adjusted annualized rate in July, the highest level since November 2007. Sales dipped to 609,000 in August but are still up more than 20% from the previous year. Home prices also continue their steady recovery, with the Case-Shiller National Home Price Index rising more than 5% year over year in July according to its most recent report. The National Index is off 2.2% from the peak (February 2006) and is up 32.1% from the post-bubble low (December 2011).
The third quarter also saw strong monthly job growth, averaging 192,000 net jobs a month compared to a 171,000 monthly rate over the first six months of 2016. The unemployment rate did tick up by 0.1 percentage points over the quarter to 5.1%. However, the good news is that this was because more people came back in to the labor market. The labor force participation rate resumed its up-trend in the third quarter, hitting 62.9% in September after bottoming out at 62.6% in May. The September participation rate is 1.9 percentage points higher than a year ago, the largest such increase since January 2007. Wages continue to grow at a 2.6% annual rate and since core inflation is running around1.7%, this means consumers are actually seeing real wage gains.
The industrial sector continues to remain the weakest part of the U.S. economy. In a sign that the vagaries of the dollar remain critical to the manufacturing sector, manufacturing PMI dipped to 49.4 in August as the dollar started to strengthen amid talk that the Federal Reserve was planning to hike rates in September. Manufacturing PMI did rebound in September to 51.5 but durable goods orders are still lower year over year, indicating that the sector has some ways to go. At the same time, it is important to keep in mind that personal consumption accounts for close to 70% of the U.S. economy, and manufacturing only about 12% of it. The latter is over-represented in S&P 500 earnings but corporate profits are expected to rebound as long as energy prices remain at the same level and the dollar stops climbing further.
Real wage growth, combined with lower gas prices, increased home values and a positive stock market have resulted in consumer sentiment hovering close to its highest levels of the cycle. Yet it is hard to escape the general, pervasive sense of gloom amongst investors, a lot of which probably has to do with Federal Reserve policy uncertainty. There is clearly a divide between the hawks and doves on the committee. This has recently resulted in market gyrations as each member of the FOMC makes a speech signaling their own preferred direction. The vote to keep rates unchanged at their September meeting included three dissents. The Federal Reserve is clearly concerned about the impact of their decision on financial markets and the US dollar, and is likely to make strong signals as to the direction they are leaning in well before the December meeting. It appears unlikely that they will raise rates at the November meeting, which is only a few days prior to the US election.
Convex’s proprietary leading economic index (CPLEI) risk rating for the U.S. rose from Hold at the beginning of the quarter to Hold-Buy in August and September, reflecting the rebound we discussed above. The portfolio’s exposure to domestic equities averaged about 49% throughout the quarter and contributed 1.63 percentage points to the fund return of 1.72%.
Monetary Policy hits a wall
The European Central Bank (ECB) left its benchmark rate unchanged at -0.40 percent and reaffirmed its Quantitative Easing (QE) program (Euro 80 billion a month) at their September 9th meeting. While there is the possibility that QE could be extended for another six months beyond March 2017, reports at the end of the quarter indicated that officials are already discussing how and when to taper the QE program. It is also questionable whether even more negative interest rates can provide a boost to European economies, especially since these rates hurt the banking sector, which is the primary conduit for lending in Europe.
With headline inflation running at 0.4% year-over-year (as of September), well below the ECB’s target of 2%, it appears that they are coming to terms with the limits of monetary policy. The onus would be on fiscal policy and structural reforms to shoulder more responsibility for economic growth.
The Bank of Japan (BoJ) has hardly fared better in reviving a moribund Japanese economy. The BoJ recently conducted a full-scale review of its policies, to gauge their effectiveness, or lack thereof, and is now taking a longer-term view to get inflation back to its 2 percent target through a more sustainable policy framework. The central bank introduced a new policy at their September 21st meeting, shifting their approach from one where they expanded money supply to more directly controlling interest rates, essentially working to steepen the yield curve. This is an implicit acknowledgement of the impact of negative rates on financial institutions, not to mention the fact that the BoJ appears to be reaching a limit with its government bond purchases (it already owns a third of Japanese government bonds outstanding).
Brexit fears receded in the third quarter as the United Kingdom’s ruling Conservative Party elected a new Prime Minister, Theresa May, in quick order. Prime Minister May was seen to be a pragmatist who could perhaps navigate Britain out of the European Union without losing access to the critical single market and London’s role as Europe’s financial hub. British manufacturing and service sectors rebounded in August and September after plunging in July.
However, it is the pound that has taken the brunt of the Brexit blow, falling 2.6% against the dollar in the third quarter, on top of a 10% plunge immediately after the vote. This has become even more obvious since the end of the last quarter. Prime Minister May recently set March 2017 as the date for invoking “Article 50” of the EU treaty, formally beginning the process of divorce from the EU. At the same time, her government seems increasingly inclined to take hardline positions against the EU during the negotiations. Given that the EU is unlikely to allow Britain access to the single market while limiting free movement of people across its borders, it seems like the process will be quite confrontational. The uncertainty has carried over to the pound, which experienced a flash crash of more than 6% on October 6th in Asian currency markets. Despite recovering from the crash almost immediately, the pound is still down more than 5% against the dollar over the first ten days of October and is now at a thirty-one year low.
Convex’s risk rating for Europe held at Caution-Hold throughout the quarter amid lackluster growth numbers across the continent. The risk rating, combined with the fallout from Brexit, precluded any investment in the region during the quarter. Japan saw its rating increase from Caution-Hold to Hold in August. However, the fund did not invest in Japanese equities due to uncertainty over the effectiveness of negative interest rates, BoJ policy and heightened volatility in Japanese equity markets.
The portfolio had a small allocation to selected Emerging Markets that were rated as Hold, namely South Korea (1% average allocation) and India (0.5% average allocation). The former contributed 0.08 percentage points to the fund return while the latter was flat. Other Emerging Markets, including China and South America, were rated at Caution or Caution-Hold throughout the third quarter.
The fund portfolio averaged a 43% allocation to fixed income and a 4% allocation to cash during the quarter. The fund started the third quarter with a 50% allocation to fixed income in light of known-unknown risks arising from Brexit, but this was reduced to about 33% in September as the overall risk rating for the World rose from Caution-Hold to Hold (on the back of positive US data). Most of the reduction was done on the short end of the yield curve, prior to the Federal Reserve’s September meeting due to uncertainty surrounding their policy. Overall, the fund’s exposure to fixed income dragged the return down by just 0.01 percentage points.
As we mentioned earlier, the US economic picture brightened during the summer. The question is whether it is bright enough for the Federal Reserve to start tightening monetary policy, and perhaps just as important, whether investors believe it to be the case. Equity markets start getting jittery every time a Federal Reserve official discusses the possibility of higher rates sooner rather than later. We do note that the current Federal Reserve Board is a very dovish one, and a 25 basis point hike is unlikely to severely crimp the economy.
Here is what we are watching in the fourth quarter:
1. Will the Federal Reserve hike rates in December, and perhaps more importantly, give a clear direction as to the path of interest rates in 2017? Or will it be a “one and done”, as the rate hike in December 2015 turned out to be. One unknown is whether the Federal Reserve will be spooked by turmoil in global markets as they signal a rate hike. The US dollar is the primary channel of concern here since it tends to rise together with the probability of a rate hike, causing turmoil in global equity markets. This is especially true in emerging markets since a significant portion of corporate debt in this region is dollar-denominated. Ultimately, the Federal Reserve will have to decide whether it wants to take the responsibility of being a ‘global central bank’ and tuned to global financial perils that can creep onto US shores.
2. The spread between US ten-year and two-year treasury yields is currently below 100 basis points, close to levels we have not seen since 2007. The movement of this spread will tell us whether or not investors believe the Federal Reserve is tightening monetary policy prematurely. Note that central bank policies in the EU and Japan have resulted in their respective long-term yields dropping to zero, and at times into negative territory, making US yields look very attractive. This puts even more downward pressure on long-term yields, not to mention the fact that US treasury bonds are the assets of choice in a risk-off environment. This brings us to our next couple of points.
3. We will be watching closely as to how China manages capital flight from an economy that is clearly slowing. China caught a breather in the first half of 2016 as dollar weakness aided their efforts in keeping the yuan (which is fixed to the dollar) depreciated against the currencies of its trading partners. However, China’s foreign reserves fell for the third straight month to below $3.17 trillion in September, a five-year low, indicating that they have resumed trying to stabilize their currency in the face of capital flight from an ailing economy. Over the first ten days of October, China guided its currency to a six-year low even as the US dollar strengthened. Two out of the three major drawdowns for equity markets over the past eighteen months occurred when the Chinese bear sneezed. This is a known-unknown risk that is also tied to Federal Reserve policy and its impact on the dollar.
4. Another known-unknown risk is the rise of populism around the world and its potential to upend existing political economies. The most obvious of these is Brexit, and the uncertainty surrounding Britain’s negotiations with the EU. These negotiations, and the inevitable posturing that precede them, will clearly have a major impact on the flow of capital, goods, services and people between the UK and the EU. The US election, scheduled for November 8th, has already resulted in rhetoric that is anti-globalization and we are watching how the major parties will reconcile the populism expressed by their presidential candidates after the election. Italy also has a constitutional referendum on December 4th, which aims to increase political stability in a country that has had 63 governments since the end of World War II, but has quickly turned into a referendum on the Prime Minister Renzi’s two-and-a-half years in office. Other countries like Spain and Brazil have also been going through significant political uncertainty, precluding any investment in these areas despite rebounding economic data and attractive valuations.
The risk rating for the world is at Caution-Hold as we move into the final quarter of the year. We continue to monitor economic prospects of thirty different countries across five regions of the globe and remain vigilant about potential risks arising from some of the known-unknown risks mentioned above.
Any statement regarding market events, future events or other similar statements constitute only subjective views, are based upon expectations or beliefs, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond Spouting Rock’s control. In light of these risks and uncertainties, there can be no assurance that these statements are now or will prove to be accurate or complete in any way. No representation is made that Spouting Rock’s investment processes, strategies or investment objectives will or are likely to be successful or achieved.
As of 9/30/16, the Spouting Rock/Convex Dynamic Global Macro Fund average annual returns since the fund’s inception on 11/24/14 are 0.75% for CVXIX and 0.46% for CVXAX, compared to 0.16% for its benchmark. The returns for the one-year period ending 9/30/16 are 7.01% for CVXIX and 6.68% for CVXAX, compared to 0.27% for its benchmark.
The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Performance data current to the most recent month end can be obtained by calling Spouting Rock Fund Management at 610-788-2128.
The gross expense ratio is 12.13% for CVXIX and 11.48% for CVXAX. The net expense ratio for both share classes is 1.10%. The net expense ratio reflects reduction of expenses that the fund’s advisor has voluntarily agreed to waive and/or reimburse so that total annual fund operating expenses (excluding brokerage fees and commissions; borrowing costs; taxes; acquired fund fees and expenses; 12b-1 fees, and extraordinary litigation expenses) do not exceed 1.10% of the Fund’s average daily net assets. This agreement can be terminated at any time.
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